Why Angel Investors Are Angry at Big VCs

Early investors claim that venture capital firms are preventing them from getting in on successful startups' later funding rounds.

There are benefits to being an angel investor. They can be the first money into companies that eventually become enormous, such as Uber and Airbnb.

For example, the first investors in Uber put money in when the company was only worth $4 million. Now Uber is a $17 billion+ company.

But as soon as a company becomes big enough to attract later-stage VCs, some of these angel investors are getting screwed over by firms with a lot more clout and cash, some angels say.

"Dear Series A/B investor: if [my fund] was in a prior round and you squeeze us out of a new round, you are NOT our friend," 500 Startups' Dave McClure tweeted last week. "Really f---ing tired of bigger investors pressuring founders not to let prior investors get pro-rata."

"Pro rata" is a concept in many private financings. It gives early investors have a right to buy a number of shares in a next round of financing to maintain the same ownership percentage they had when they first invested. So if an angel investor puts in $500,000 and owns 10% of the company, then the investor can put more money into the next round to maintain that 10% ownership. Angel investors have to have deep pockets to be able to match subsequent rounds however, which can require $1 million+ size checks to stay in the game.

The extra shares that the early investors buy come with a cost. When early investors maintain their pro-rata stakes, one or both of two things happen: 1) New investors get a smaller stake in the company than they might like (because existing investors are buying some of the newly issued shares), and/or 2) existing investors, including company management, suffer more dilution because the company issues more shares. As a result, there are often negotiations around pro-rata allocations, with each class of investor lobbying for its interests.

Recently, say some angels, some big VC firms have begun to put pressure on company founders to NOT give early investors the chance to buy their pro-rata stakes -; either by persuading them not to exercise pro-rata rights, if they have them, or by not even telling them about the new financing in advance. This prevents the angels from maintaining their stakes in their successful portfolio companies-;the ones that raise additional financing. This, in turn, reduces the angel investors' long-term returns and makes the profession more risky.

Here's how angels get squeezed out:

A startup goes to raise a new round of financing and talks to big firms like Sequoia Capital, Benchmark, Andreessen Horowitz or Khosla Ventures to lead their Series A or B round of financing.

The big VC firms often have a minimum ownership percentage they'll accept, between 15 and 25 percent

The founders, who want to work with the top firms but don't want to be insanely diluted, then feel pressured to leave their early supporters, the angels, out of the fundraising process to make room for the 15-25 percent.

This leaves the early investors angry at the founders who aren't confident enough to go to bat for them against big-name investors, and angry at the big VCs for wanting such high percentages that the angels get pushed out of deals.

"A common scenario is either 1) seed investors have no pro rata rights and are fully excluded [in follow-on rounds] or 2) they have pro rata rights but the A/B investors say they won't do a deal unless the founder forces earlier rounds to not take their pro rata," an early stage investor explained to Business Insider via email.

So who's right, who's wrong, and who's getting screwed?

The Angel's Perspective: "I Found It First"

Since angel investors are the first to bet on startups, they want to make sure they're rewarded for that risk.

"I feel like I took the biggest risk coming in at the very beginning and with that I want to continue keeping my percent of the company," angel investor Joanne Wilson writes on her blog. "Most VCs use documents on their Series A that say unless someone (angel) invests a significant number (say $350-1M) then they cannot continue with their pro-rata rights on the next round. I think it is absolute bullshit. The VCs should allow the angels to continue to put in their pro-rata share if they want to."

Another early-stage investor referred to some large VC firms as "assholes on the cap tables" who "have no respect for the people who worked hard to help the founders create the value to date."

One firm this person named, Andreessen Horowitz, denies the claim. "We always try to be fair to early investors, especially angels," Andreessen Horowitz partner Margit Wennmachers tells Business Insider. "Most of [our partners] were angel investors at one point. I think they get that point of view from personal experience."

Sometimes, its not an VC's fault when an angel investor gets screwed over. Founders can be so eager to work with a prolific VC that they forget to look out for their early supporters.

"Founders at that early stage are often deer in the headlights when a big famous firm of blue shirts and khaki pants makes a request [to not accept an angel's pro rata rights]," an angel investor tells Business Insider

The VC perspective: "We want a big chunk and we don't care how we get it"

VCs know what percentage of a startup they need to own for their investment to be worth it.

"Over 40 years of VC history it's been proven that if you don't own 20 percent or more in a Series A, you're just not going to have a successful fund," one investor tells Business Insider.

But to angels, these high percentages seem ridiculous and greedy.

"One thing these investors care about more than anything else is total ownership percentage," one angel tells Business Insider. This person recounted a time they were working with a VC who was a new partner at a fund. This person confided that "all he was judged by in the partner meeting was his percentage of ownership. Not the price. Just did he manage to get 25 percent or not."

Some top-tier firms admit they require higher percentages than others for their "premium" services. One VC says paying to work with a big-name firm over a cheaper, no-name firm is like choosing to drive a Porsche instead of a Toyota. When you consider that a VC-startup partnership can last ten years, a lot of founders will choose to pay up, even if it comes at an angel's expense.

"I get myself out of the middle," one VC explains. "I make the entrepreneur a post-money offer and say hey, 'We're going to invest $5 million on a $28 million post-money valuation. What I care about is my percentage. An entrepreneur can take more money from anyone else they want, but it comes at their expense. It dilutes them, but my negotiation with the entrepreneur is already complete."

The Founder's Perspective: I Don't Want To Get Diluted

VCs might apply pressure, but the decision to honor an angel's pro rata rights ultimately comes down the founder. The founder has to decide how much dilution he or she is willing to take, and how much each angel has contributed to the company's early success.

Sometimes angels who haven't done much for companies try to overstep their legal rights.

"Most of the time, a VC will be accommodating to an angel's pro rata rights," a VC tells Business Insider. "But if an angel comes out of the blue and hasn't negotiated those rights previously then says they want them we say, 'No f---ing way.' Often, they haven't been cheerleading the whole time."

If an angel has been very helpful to a startup, some founders will go to bat for them and ask VCs to make room in the Series A or B rounds.

Airbnb CEO Brian Chesky, for example, fought to get pro rata rights for Keith Rabois and Kevin Hartz when Greylock led the first big round. Airbnb has gone on to raise hundreds of millions of dollars and it is now worth $10 billion.

"That's common to see," Rabois tells Business Insider. "When a specific person has been helpful, the founder will ask the VC, and almost everyone will be fine with it."

It's hard to please everyone though. One founder who has worked with both angels and large VC firms says keeping investors happy is "always a dance."

"A newcomer is usually investing because they're very excited about the startup amd they want to get their chunk of it--they don't want to do all the work and only have a small chunk," the founder tells Business Insider. "If you have deep-pocket investors already in, they want to maintain their share and support it, too. You have to balance everything together and you have to try to do the best by everyone."

When the balance gets too difficult, VCs often make good scapegoats for founders. It's easier to say a founder is feeling pressured by a VC then to tell an angel they haven't been helpful and don't deserve their pro-ratas.

McClure acknowledges that sometimes, angels could do more to make sure they don't get diluted.

"It's unclear whether the responsibility is on the founder, new investor, or even us for not working harder on behalf of the company," McClure tells Business Insider of being left out of deals. "In fairness to founders, if they don't feel investors are working on their behalf, they have no moral obligation to offer allocation to previous investors."